Loans & Debt
Almost everyone will find themselves having to borrow money at some point in their lives. Whether it is a credit card purchase, student loan, car loan, or a home mortgage, it is important to have a basic understanding of debt and how it affects your finances. Do you understand the consequences of not making loan payments (defaulting)? Do you realize that any past and present reckless financial behavior may prevent you from getting financing for a car, a home, or to start your own business? Do you know how compound interest works, and how it affects the total amount you pay for something if you borrow to purchase it? Do you know the difference between good debt and bad debt, and which loans to avoid altogether?
Americans in Debt:
A trillion dollars in credit card debt
Student debt now tops $1.4 trillion
Over $1 trillion in outstanding auto loans
Unless you were born a trust fund baby, it is virtually impossible to go through life without borrowing money. The decisions you make when taking on debt will have a deciding factor on how much gold, if any, is waiting for you at the end of your rainbow. Every loan consideration should be treated as a business decision that fits in with your long term goals, and needs to include weighing the pros and cons, a cost/benefit analysis, and identifying the impact it may have on your financial well-being.
Secured vs Unsecured Loans
A secured loan is one in which the borrower guarantees the bank will repaid by putting up a certain asset as collateral. In the case of an auto loan, if the borrower stops making payments, the vehicle can be seized, sold, and used to repay the bank or finance company. In this case, it is the vehicle that is used as collateral on the loan. Examples of other items that are purchased using secured loans include homes (mortgages), recreation vehicles, farm equipment, construction projects, home equity, etc.
An unsecured loan does not require collateral, but rather relies on your income and credit history. The financial institution granting the unsecured loan is taking on a lot more risk, so the loan amounts are lower and the interest rates are higher. Examples of unsecured loans are credit cards, lines of credit, and student loans.
Loans offered to students who are pursuing higher education can be a lifeline to families that can’t afford the costs of college and university. Check your area for availability of not only loans, but also grants and bursaries that don’t need to be repaid. Proceed with caution in all your choices, so you don’t end up with a $60,000 student debt and find out later that there are no job prospects in the field you chose.
A loan that is secured by the title to a home is called a mortgage. Maximum time limit to repay a mortgage is usually between 25 and 30 years, depending where you live. There are a lot of costs, legalities, and potential problems to consider, so it is important to get quality advice from someone who has your best interests in mind.
Line of Credit
A line of credit is a pre-approved amount that you can borrow from the bank at any time. It is very flexible and allows you 24/7 access to any amount up to your limit. You can make interest only payments, or repay it in part or in full, and still have access to the full credit line limit without reapplying. Funds can be obtained by writing a check, ATMs, or through online banking. If used responsibly, a line of credit is good backup option if you don’t have an emergency fund.
Cosigning a Loan
An auto loan is a secured loan, meaning if you stop making payments, you risk losing your vehicle. Some car dealerships have their own financing, but you should always compare the interest and fees they charge to what other financial institutions have to offer. The interest rate charged will depend on your income and credit rating. Automobiles depreciate so rapidly, it is a good idea to only buy one that you can pay off in five years or less.
An personal loan is usually unsecured and used to fund anything from weddings, vacations, furniture or appliances, paying off other debts, etc. Amounts and interest rates will depend on your income and credit history.
A payday loan is a short term, extremely high interest loan, that is usually guaranteed by the person’s next paycheck. They are notorious for preying on people that can’t afford it, and should be avoided except for an emergency where there are no other options. For help during financial emergencies, check our list of resources here.
Debt Consolidation Loan
This type of loan is used to consolidate multiple unsecured debts into one manageable payment. It frees up money from multiple payments on higher interest loans and credit cards, that can be used to pay down debt even faster. Debt consolidation should not be used if you are simply wanting to free up some ‘shopping space’ on your credit cards. It can also be very damaging to your credit score, and may affect your ability to get a loan for up to seven years.
Collateral is an asset that is pledged as a guarantee of payment, when taking out certain loans. In the case of a mortgage, the house is the collateral. Auto loans use the car as collateral, and if the buyer doesn’t make the payments, the vehicle can be seized by the lender.
Home Equity Loan
If your home is worth more than you owe on it, you may qualify for a home equity loan. It is a secured loan that allows you to borrow a certain amount of money to be repaid in equal payments over a specific time period. This type of loan is best used for renovations or repairs that will maintain or increase the value of your home, but can be used for other expenses. If you plan to sell your home and the loan is not yet repaid, it will be paid out of the sale proceeds.